When £5,000 of dividends are not tax free?

The legislation that followed detailed that this is not an allowance (such as the personal allowance). It was actually a zero rate of taxation that would be applied to the first £5,000 of dividends received by an individual.

Whilst that may seem to be a technicality, it does have several knock-on effects for advice. As these new rules came into effect on 6 April 2016, it’s probably time for a refresher on this.

Trusts

The change is for individuals, so for trusts you have to look through this and determine who is liable for any dividend income taxation.

For interest in possession or absolute (bare) trusts it is the beneficiary who is assessed for income tax. Therefore, the £5,000 dividend nil rate will be available.

For discretionary trusts, the £5,000 dividend nil rate will not be available to the trustees, as by definition these are not individuals. Discretionary trust income is taxed with the first £1,000 at standard (basic) rate and the remainder at additional rate. So if there are dividends within the £1,000 band, they will be taxed at 7.5%. Anything over & above this is taxed at 38.1%.

So while there is no zero rate to be used, it’s not all bad news for the discretionary trusts though.

On distribution from a discretionary trust to the beneficiaries, it is treated as trust income, rather than dividends. So this would be taxed at the trustee rate of 45%. Beneficiaries who are not additional rate taxpayers can reclaim the tax paid over their marginal rate.

Tax Bandings

The fact that this is not an allowance could lead to confusion for individuals who are not aware of the correct detail in the legislation.

To illustrate this, if we assume that an individual has income of £41,000 and received dividends of £7,000, they may misunderstand the application of the tax rules.

The individual would assume that the first £11,000 of income is not counted owing to the personal allowance. The next £30,000 of income would be subject to basic rate tax of 20%. If the individual believed at this point that the dividend ‘allowance’ worked as per the personal allowance then they may exclude this first £5,000 and then believe that the remaining £2,000 of income would then fall within the basic rate band and only 7.5% taxation would be due. This would equate to £150 of tax due on the dividends. But this would only be the case if this were an allowance.

The way the taxation of this works is illustrated below:

Graph

As can be seen, the key message above is that the zero rate of dividends does count towards the individual’s adjusted net income. This gives rise to £500 more in taxation than the individual was expecting as the last £2,000 of dividends falls fully within the higher rate tax band.

Tax Traps

As per the section above on tax bands, a misunderstanding of allowance/zero rate would lead to an individual inadvertently falling into a tax trap. An easy example of this would be an individual who has £99,000 of income who then receives £5,000 of dividends. Even realising that this is not an allowance but a zero rate of taxation could create complications without factoring in adjusted net income (ANI).

This £5,000 may be taxed at zero, but that doesn’t mean that more tax is not due on this because of the ANI effect. The dividends give the client an ANI of £104,000. However for every £2 of income above £100,000 an individual loses £1 of personal allowance until they have no allowance left. So for the 2016/17 tax year this trap exists for ANI between £100,000 to £122,000.

Whilst the dividends are still taxed at 0%, by losing £2,000 of personal allowance the individual therefore has £2,000 of income that falls into the higher rate band, this affect the taxation as below;

Before

                          Income in Band

                  Tax Rate

             Tax

Personal Allowance

£11,000

0%

£0

Basic Rate

£32,000

20%

£6,400

Higher Rate

£56,000

40%

£22,400

£99,000

£28,800

 

After

                          Income in Band

             Tax Rate

             Tax

Personal Allowance

£9,000

0%

£0

Basic Rate

£32,000

20%

£6,400

Higher Rate

£58,000

40%

£23,200

Dividends within zero rate

£5,000

0%

£0

£104,000

£29,600

This means the effective rate of tax 60% on income between £100,000 and £122,000 for 2016/17 (40% tax on the £2 plus 40% tax on the lost £1 = £1.20/£2).

So what can be done?

An easy and simple way to mitigate any extra tax paid by falling into a tax trap is to make a pension contribution.

If we take the example in the tax trap section as the client has £4,000 over £100,000 of ANI, then a £4,000 gross pension contribution will regain the full personal allowance. If we assume that this is made under a relief at source scheme this initially costs the client £3,200. There will then be a reduction of £800 in the client’s  tax return which means the effective cost for £4,000 of pension is £2,400.

This would alter the tax position to become;

After pension contribution

                       Income in Band

                Tax Rate

                      Tax

Personal Allowance

£11,000

0%

£0

Basic Rate

£36,000

20%

£7,200

Higher Rate

£52,000

40%

£20,800

Dividends within zero rate

£5,000

0%

£0

£104,000

£28,000

The gross contribution of £4,000 has saved £1,600 in tax and received relief in the pension of £800 – an effective rate of tax relief of 60%.

So whilst the individual may be ‘disadvantaged’ by having given up the immediate access to the £2,400 net spend to this, it will arguably make the individual richer.

Assuming no growth on the pension contribution, an individual taking the 25% pension commencement lump sum, and the remaining income taxed at marginal rates, the table below highlights the net return. As can be seen the pension contribution not only reduces the tax bill, it will give the individual in this scenario more of a return on their money. Even in the unlikely event that the client moves from higher rate tax to additional rate when benefits are taken there would be a 10% return on the contribution.

                          PCLS

         Tax at          marginal rate               Net       Benefit

            Gain on         £2,400 net cost

Nil Rate Taxpayer

£1,000

£3,000

£4,000

67%

Basic Rate Taxpayer

£1,000

£2,400

£3,400

42%

Higher Rate Taxpayer

£1,000

£1,800

£2,800

17%

Additional Rate Taxpayer

£1,000

£1,650

£2,650

10%

In summary

The changes to dividend taxation affect many individuals, some more obviously than others. Limited company owners taking dividends of more than basic rate will be affected but so will individuals  taking dividends. For non-business owners, the changes are a key factor in deciding what wrapper(s) will  be most suitable for an individual’s circumstances. To determine this  the interaction of the individual’s other income with dividends is key.

 

 

 

Source: Prudential